Education Loan interest rate is simple or compound?

When taking an education loan, the most important thing people look for is the rate of interest. How much they have to pay on top of the money they have loaned is something that matters to every borrower. While doing their research on education loans every student comes across the terms simple interest rate and compound interest rate. There will be confusion on how simple interest is charged during the moratorium period, and how the interest rate starts compounding after that.

It is very important for students to clearly understand the difference between the two and exactly understand how both of them play an interconnected role in how banks charge interest on the loans they give out, how the repayment period affects the total amount you pay back, and much more. 

Knowledge of these terms helps students understand the jargon and not be misled by the confusion banks can sometimes put the students through which can end up in paying more than they have to. Keep reading to learn more.

A simple interest is charged on your principal loan amount. This means that the interest will only be charged on the loan amount you borrowed from the bank.

The formula of simple interest:
Simple interest (SI) = (P × R × T)/100

Where,
P = Principal amount (The loan amount you take)
R = The Rate of Interest charged 
T = The tenure of your loan

So when simple interest is charged,

The total amount you’ll have to pay = Principal amount + Accumulated simple interest amount.

Let’s understand the concept with the help of the following example:
Your education loan amount is Rs. 10 Lakhs, and the interest rate is 10% p.a. for 5 years. A 10% simple interest on Rs.10 Lakhs comes to Rs.1 Lakh as the annual interest amount. So, at the end of 5 years, the total loan amount would be Rs.10 Lakhs (Principal)+ Rs.5 Lakhs (accumulated interest amount) = Rs.15 Lakhs. Now let’s understand compound interest concerning education loans.

When you take an loan in terms of compound interest, you pay interest on the initial loan amount and any interest that has accumulated over time.

Formula of Compound Interest:
Compound Interest  = P ( 1 + r/n) ^ nt - P

Where,
P = Principal amount
R =  The rate of interest 
N = Number of times the ROI is compounded every year
T = Loan repayment tenure 

So when Compound Interest is charged,

The total amount you = Interest on (Principal amount + Accumulated interest amount).

Let’s try to understand this concept in terms of the same example as above:

You borrowed an education loan of Rs.10 Lakhs at 10% p.a. for 5 years. According to the compound interest terms, with annual compounding, the interest amount for the first year will be calculated as:

Rs.10 lakhs (Principal loan amt)+ Rs.1 Lakh (accumulated interest for one year) = 11 Lakhs (1st year)
Rs. 11 Lakhs + Rs.1.1 Lakh (including annual compounding)= 12.1 Lakhs (2nd year)
Rs.12.1 Lakhs + Rs. 1.21 Lakhs (annual compounding) = 13.3 Lakhs (3rd year) and so on.

So, by the end of the 5th year, the student ends up paying Rs. 16.1 Lakhs as the total loan amount.

Apart from simple and compound interest, there is another form of interest known as partial simple interest. In the case of partial simple interest, the student only pays a certain portion of the simple interest, and the remaining amount gets added to the principal amount.

After the SI, CI, and PSI are calculated it is added to the principal amount which is the loan amount you have taken, and the total amount or EMI is calculated. 

Total amount you pay = Principal amount + Interest calculated on the principal amount (simple/ compound)

Coming to the partial interest payment, this feature was introduced to facilitate students who have to pay higher amounts than usual, as interest. They have considered the fact that such students may not be able to make full payment of their interest in one go.

The main talking point about this feature is that when a student only pays partial interest, then how do compensate for the rest? 

This difference between the amounts is automatically accumulated and is compounded to your principal amount.

Let’s understand this with the help of an example:

When the actual interest to be paid is Rs. 12,000 per month, Credila representatives give you the offer to pay the partial interest of only Rs. 5000 every month. In this case, every month, the difference amount of Rs. 7000 is automatically added to the next month’s principal. This is exactly how compound interest works! But on the other hand, let’s assume that the student manages to pay the entire interest amount every month. In that case, there won’t be any amount left to add to the next month’s principal as compound interest.

The education loan interest rate calculation of most of the government banks is done on a simple interest basis. As opposed to private lenders, public banks calculate your monthly interest amount purely on a simple interest basis during the moratorium period (i.e. Course duration + 6 months after the course). Private lenders usually give loans with compound interest which means you will end up paying a large amount of money on top of your principal loan amount.

Also, if an applicant borrows an education loan from a public bank, they don’t even have to start paying the interest amount until after the moratorium period. You still stand to benefit from this factor.

Take this for an example:

If you apply for a Rs.10 Lakhs loan from a public bank at a 10% interest rate p.a., Then at the end of 2 years, you end up paying back Rs.12 Lakhs only, (Principal amount + Simple interest @10%p.a.)*2. 

When you decide to approach private lenders, keep a close check on their education loan interest rate terms and conditions. They will try to make it look like their interest rate policies are at par with public bank terms. However, by now you know that’s not the case. Know more on how you can catch these private lenders fooling you by watching the 12th episode of the Loanflix series. Our expert tells you a very simple hack on how to do it. If you do like this episode, don’t forget to watch all the previous episodes of Loanflix, a comprehensive web series on education loans and more.

Now that you've got a hang of the education loan interest rate terms and conditions, what do you do if you have borrowed an education loan from a very expensive lender and now you want to reverse your decision? How do you do it? Stay tuned for our next article, which will tell you all about the Education loan takeover.

Speak with our financial officer to get help and assistance. Also, check your eligibility for the best education loans matching your profile.